The Sliding Dollar

August 21, 1978

THE RISE IN INTEREST rates Friday was the right opening move. In the past several weeks, the fall of the dollar's value on the world's currency markets has suddenly become much more dangerous. It was urgent that the Carter administration and the Federal Reserve Board respond. The Fed has increased its discount rate - the rate at which it lends to commercial banks - by half a percentage point. That's a necessary remedy, but it's not sufficient. What comes next?

Over the winter and spring, the administration's posture of benign neglect of the exchange rates was perfectly reasonable. Most of the movement was modest. The principal exception was the rise of the yen, resulting from Japan's huge and persistent trade surpluses. But since the beginning of July, things have changed sharply for the worse. Now the dollar is falling against most of the world's major currency, the weak as well as the strong. The reason for this ominous change is a spreading impression, among currency traders and bankers, that the U.S. government either can't or won't reduce the level of inflation here.

Exchange rates are swayed by people who have to gamble on the values of currencies months and years ahead. If they think that the dollar is going to depreciate faster than other kinds of money, they sell - and the prediction quickly tends to become self-fulfilling. When people sell dollars, the exchange rates fall. That increases inflation in two ways. Import into the United States become more expensive and some of the domestic industries - steel, for example - happily raise their own prices as the competing foreign products get more expensive. At the same time, American goods become cheaper to foreign buyers who bid up prices for Americans. Inflation and exchange rates are not separate issues.

How do the financial markets make up their collective minds about American intentions? The last two months provide a good illustration. At the end of June, the Secretary of the Treasury, W. Michael Blumenthal, said at the National Press Club that the Federal Reserve Board's high interest rates were forcing the administration to lower its estimates for economic growth. On the same day the Fed voted to raise the discount rate by a quarter of 1 percent. But it was a split vote, and the Fed's new chairman, G. William Miller, had dissented. Currency dealers concluded that the administration was putting pressure on the Fed not to interfere with growth, and it had won over Mr. Miller. In July, Mr. Miller seemed to confirm that assessment when he began saying that interest rates would peak soon, he hoped, and begin to decline before the end of the year.

Meanwhile, the administration's energy program was in endless trouble in Congress. Financial experts, here and abroad, took that as a clear indication that the United States would do nothing about its inordinate imports of oil. They are contributing, of course, to inflation and the weakness of the dollar.

In late July, the government published the usual statistics on the nation's economic performance in the previous three months. They showed an inflation rate over 10 percent a year. It meant that inflation was rising here, while falling in most other major economies. It also meant that the Carter administration had underestimated the speed with which prices were rising. The decline of the dollar began to accelerate.

Last week Mr. Carter summoned Mr. Blumenthal and Mr. Miller to discuss the dollar. The White House subsequently put out a statement to the effect that they would consider what to do. But, when you say that you will have to consider what to do, you inevitably leave the impression that you have no clear line of action in mind. The currency markets began to bounce around wildly. Then, on Friday, the Fed raised the discount rate again.

The conventional objection to higher interest rates is that they threaten to choke off business expansion and tip the country into a recession. But there is no simplo choice between inflation and recession. Inflation at the present level will produce a recession - and, to judge from the 1974-75 experience, it can be a recession of great severity.

To bring down the inflation rate will require further increases in interest rates. It will require firm decisions to hold down oil imports. It will require a federal budget of great stringency. It is not a pleasant prospect. But if it seems to you excessively harsh, think for a minute about the alternative.